Why trading water futures could be in our future

CNBC's Patti Domm discusses the controversial topic of trading water and what the future of that commodity may look like.

Water is the one natural resource required to sustain all life on the planet, making it already the most important commodity on Earth.

Although it has been fought over, sold, diverted, dammed, claimed by governments and overseen by authorities, Wall Street has never really gotten its hands in it the way it has with, say, oil.

Looking ahead into the next quarter century, clean drinkable water is expected to become more scarce as the human population grows and climate change shifts the shorelines and weather patterns.

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So the question is, Will this most precious commodity become a traded resource that will be bartered for, and traded on a futures exchange, much like oil, corn or gold?

"It's intuitively appealing to talk about water as a traded asset. If you look at projections over the next 25 years, you'll see that global water supply and demand imbalances are on track to get worse," said Deane Dray, a Citigroup analyst who heads up global water-sector research. "The majority of the world population is living in water-scarce and water-stressed regions of the world. "

But Dray and other experts say trading water will be difficult, as water supply is ultimately a local issue all over the world.

"I don't see how you would do it. Water's regulated locally. It's regulated in every state. You can't put a pipe in a waterway and start selling it somewhere else," said Robert Kennedy Jr., president of Waterkeeper Alliance, which promotes watershed protection globally. "The waterways are owned by the people of the state."

History is full of examples where water diversion led to wars or environmental tragedies. The former Soviet Union diverted rivers for crops in the 1960s, ultimately drying out the Aral Sea in Central Asia, where fishing boats are now stranded on dry land.

"Anything that ships water as a commodity out of a watershed would be extremely disruptive environmentally, and it would be disruptive to democracy and the public trust. We've already seen water wars all around the world because of companies trying to do that and governments trying to do that," Kennedy said.

The Middle East has seen many conflicts over water, including in Syria. The Euphrates River has long been a source of conflict between Turkey and Syria, and in the last month Turkey turned off the tap, affecting water flow to Syria and Iraq.

Kennedy said Western law, dating back to Roman times and even the Magna Carta, stated that water belongs to the people.

"Water is a multitrillion-dollar industry now, according to the World Bank, and because it is a commodity that is vital for human life and we're experiencing global shortages because of global warming and population growth ... it's something [that] people will try to figure out a way to commoditize and sell," Kennedy said. "The best measure of how a democracy functions is how the government distributes the goods of the land."

"Economists like the idea of trading [commodities] freely. The process increases economic efficiency," said Professor John Reilly, co-director of the Joint Program on the Science and Policy of Global Change at the Center for Environmental Policy Research at MIT Sloan School of Management.

"In terms of large-scale international trading of water, we already have bottled water moving around. I think its more likely we will see desalinization and other sorts of things—such as water reclaimed, cleaning up and recycling of water—before we see large-scale trading of massive amounts of water, because it would be expensive to move," said Reilly. He said a solution to lack of water may be to move activities that require water, like crop production and manufacturing, from dry areas to wetter regions.

Necessity the mother of invention

Richard Sandor, CEO of Environmental Financial Products, said he believes obstacles will be overcome, and he fully expects to see trading of water via financial instruments in the next five to 10 years—something he's been thinking about for quite some time.

Sandor was behind the creation of interest-rate futures while working as an economist at the CME, and he also was behind the Chicago Climate Exchange, a North American trading system for greenhouse gases, now owned by ICE.

"I think this one is going to require invention. The physical limitations of piping water is a problem that will require creativity," he said.

The more important issue is how to price such financial instruments. As Sandor explained, "The delivery from futures is very small. They're really meant to keep the pricing honest, not to change ownership. The delivery and the threat of delivery is what keeps a price honest and fair, at least on the derivatives side."

Sandor said water trading would have to based on the dynamics of regional markets, and he's been working up a plan. "I think we're going to have to invent something that takes into account the varying geographical differences. We'll have to figure that out," he said.

The U.N., in its 2014 report on world water demand, said demand is expected to grow significantly with the largest growth in the emerging world. Agricultural water consumption could grow by about 20 percent globally by 2050, not counting new efficiencies or conservation.

Water demand for energy could increase by about a third in the period between 2010 and 2035, with non-OECD countries accounting for 90 percent of the growth. The OECD projects fresh water will be increasingly strained with an additional 2.3 billion people living in areas that are highly water stressed, like North and South Africa and South and Central Asia, by 2050.

At the same time, the U.N. paper notes that climate change is impacting surface water, and dry regions should get drier while wet regions will get wetter. The U.N. notes there's also evidence groundwater supplies are diminishing, with an estimated 20 percent of world aquifers overused. Groundwater abstraction is increasing at a rate of 1 percent to 2 percent a year.

"Water is always a local issue. It's prevalent in areas you don't want it, and that's flooding, and it's scarce in areas you do need it, and that's overly populated areas and arid areas. Water is costly to transport. It costs more to pipe water than it does to pipe oil," Dray said.

As for pricing, every country values it differently, and there's no uniformity at all. For instance, Dray said, water is free in Ireland. "They consider it a right. That's part of what you have to overcome. Twenty-five years is a long time for some of these notions to change," he said.

In contrast, Danish consumers pay the most for water—at an estimated average $3.88 per cubic meter, and $8.45 when wastewater charges are included, according to Global Water Intelligence. In the U.S. the average is about $1.48 per cubic meter of water, and in Germany $3.08. Sandor points out that these are the prices of water and infrastructure, not the price of water alone.

Dray also noted that water is the only natural resource that is ingested. "Twenty-five years is a lot of time for things to change. Water demands will increase at a faster rate than supply. Some of the notions about and preconceptions about water being a right could change," he said.

"I do believe [water] will be the commodity of the 21st century."-Richard Sandor, CEO, Environmental Financial Products

Mark Fulton, founder of Energy Transition Advisors, said the evolution of markets and the changes in the climate over the next 25 years could bring about new systems for trading water and other environmental rights. Fulton is an economist with a background in climate change and markets. He also is a senior fellow with Ceres, a nonprofit that aims to advance sustainability practices globally.

"Global warming is the key driver of climate change, but one of the key aspects of climate change is climate variability," he said. "In a sense, we're going to see more disruption to natural systems, and therefore the property rights over those natural systems are going to have to be properly managed."

Fulton noted there is trading of water rights in Australia and, to a lesser extent, in the Western U.S.

"There are plenty of trading-based water systems. There are versions of them. Will they make it to exchanges? The more this happens and the more it becomes accepted, the more it will become mainstream," Fulton said.

The new liquid gold

Governments may also provide the solution of pricing and distribution. "A couple years ago it was a big focus in China. There was the big question of Yangtze and Yellow Rivers, and they were managing by telling people who would get what and where. They took central management over it," Fulton said.

The drought in the West has put a spotlight on the problems of managing water resources. Climate change and overuse is making the Colorado River supply tight and could result in severe shortages. The Colorado River Compact was made between six of the seven river basin states in 1922, and while it's been revised, it still pits the southern agricultural regions of California, especially in the Imperial Valley, against residential centers in other states. The California farms are dependent on the Colorado River, and so is the rest of the country, since 80 percent of winter vegetables are grown there.

One of the reasons trading water like a commodity makes sense to some is that it is so tied to agriculture and energy. Water is not only used to grow crops, it is used to create hydroelectric power and for hydraulic fracturing. Energy is used to pump water and harvest crops, and water is critical in cooling power plants.

"I do believe it will be the commodity of the 21st century," said Sandor.

"We think we know how to do it in theory. We have a lot of details to work out. I've been hearing this for years. 'You could never commoditize interest rates. That's a stupid idea.' ... I think in fact it can be done," he said.